Municipal Bonds: a Safe Bet or an Accident Waiting to Happen?

We have all been told that municipal bonds might not be flashy, but they are safe. Now, however, that advice might no longer hold says Michael Dean from the company office where he offers QROPs advice. Defaults are on the rise.

You have heard this litany so many times you could repeat it by rote: “If you want a safe investment, get a municipal bond. Sure it will not make you rich. It is not even designed to do that. But it will give you a dependable income (interest) and your money will be secured.” Those sellilng points might sound good in theory, but what exactly are the facts.

Municipal Bonds are Safe Until They are Not

Well, the title of May 28, 2010 CNN article by Sara Behunek “Three American cities on the brink of broke” might sound foreboding, but this piece does offer some reassurances. It notes that the average five-year cumulative rate for investment-grade municipal bonds is less than half a percent. That figure represents about one-third the comparable figure for corporate debt.

The message these figures parlay is obvious: Sometimes, you just have to do the best you can do and not let yourself be “paralyzed” by the “hazards” which surround an investment, be it munis or anything else for that matter, because there are no “perfect” investments in the same way there are no perfect anything else. Unless you accept that essential reality, you might not make purchase that will turn out to be a good mix for your portfolio.

And there are factors other than their relative safety which might make municipal bonds, often called “munis,” appealing. They are tax advantaged; depending upon the specifics you might not have to pay either state or federal taxes on the interest you receive. This bolsters their effective rate of return.

Another major bonus for munis: Investors can put their money in a bond issue which funds projects that directly benefit the community where they live, according to a July 29, 2010 dailymarkets.com article by Martin Hutchinson “Municipal Bonds Not As Safe As Brokers Say They Are.”

However, the water in this glass might be too murky to call it either half empty or half full. The same CNN article which commented favorably on munis’ dependability goes on to note that times are changing and the meaning of “safe” changes with them. No, munis are not defaulting at alarming rates. But they are no longer necessarily a sure thing if in fact they ever were.

By 2012 municipal governments will probably have accumulated a budget shortfall of between $56 billion and $83 billion — a huge sum that represents the tab for decades of binge spending, according to the CNN story.

And these budget crunches have already brought bond defaults in their wake. During 2009, 183 borrowers, many of them “risky” municipal issuers, such as suburban developers in Florida, failed to repay bond holders; the losses to borrowers totaled $6.4 million.

An example of a bond issue gone sour: Harrisburg, Pennsylvania owes $68 million on bonds it issued to construct a state-of-the-art trash incinerator. That figure exceeds its entire annual budget by an estimated $3 million. The state of Pennsylvania clearly indicated it will not bail out this city; so, it is shifting through its possessions to see if it has anything that could be sold on eBay before the next payment comes due, the CNN article reports.

Now, you might be able to protect yourself against such losses by looking at the ratings that various agencies assign to a bond before you purchase it. The way things are supposed to work: The higher the rataing, the lower the chances of a default. But as the dailymarkets.com article notes these agencies are the same ones that essentially failed to warn the public against investing in subprime mortgage instruments. So, why, the dailymarkets.com article it asks should investors place be inclined to trust them?

Some More Complications

And there is another consideration that should be taken into account, ne that deserves close attention no matter what the economic climate. Interest rates do not hold constant. Rather, they fluctuate and as they climb the value of a bond declines commensurately.

For example, if you purchase a bond for $10,000 and it pays 2.5% interest, your investment might decline to $9,500 if interest rates rise. That might not represent a major shellacking, but it represents a loss none the less, a moneycentral.msn article “Are bonds the next bubble?” notes.

Now, any loss that investors experience on a municipal bond, while it winds its way towards maturity might be considered nothing more than a “paper loss.” Investors can always simply hold a bond to its maturity date, the moneycentral.msn article notes. At that point, as long as the issuer remains solvent they will get the face value of their bond returned to them. But waiting to get your pay-off is not always easy.